Gov Capital Investor Blog

What Influences Stock Prices and Can They Be Predicted?

We all know one of the most basic facts there is to know about the stock market: it is risky due to the ever changing, almost completely unpredictable prices. Moreover, the fluctuations in stock prices are so frequent that an entire industry has been built on forms of trading where shares are bought and sold within the same day, sometimes only being held for minutes or even seconds.

In this article we are going to discuss the factors that have an impact on the prices of the stock market.

The most fundamental principle that lies behind stock prices is the balance of supply and demand. You have probably heard these words as they play an important role in every area related to trading. The basic idea is that when demand (the number of people looking to buy) is higher than the supply (the number of people looking to sell), the price of a given stock increases. On the same note, when demand is lower than supply, the price goes down.

While this sounds very straightforward, what really matters is the answer to the following question: what makes people favour certain stocks over others? This is important to consider, as, in theory, stock prices are purely the reflection of how investors value a stock and what they expect from a company in the future.

Therefore stock prices are not necessarily accurate reflections of a company’s value. The latter is most often expressed in the company’s market capitalisation, which is the stock price multiplied by the number of shares outstanding (the number of shares currently owned by investors). Another important indicator – that is often used by analysts to predict future possibilities – is the earnings of a company. Obviously, sufficient income is essential for every business in order to continue growing. Public companies are required to publish earnings reports four times a year, and whether they exceed expectations or underperform directly impact the current price of their stock.

In conclusion, the supply and demand, the market capitalization and the company’s earnings all impact investors’ valuation of a company. However, the stock market wouldn’t be as unpredictable as it is if things were this simple. Historical examples show that it is possible for stocks to be overvalued, and market capitalization can rise even if the earnings stay low.

For instance, during an ominous time period in the 1990s – referred to as the “dotcom bubble” –, thousands of Internet start-ups were born and hopes were high, as the Internet brought along hitherto unimaginable possibilities. The dotcom bubble was mostly the result of speculative investing, with many otherwise cautious investors abandoning their strategies and joining the dotcom bandwagon out of fear of missing out. The stock market saw incredible growth from 1995 up until 2000 and the market capitalization of even small start-ups skyrocketed, while these businesses weren’t able to make enough profit on the long run.

The NASDAQ index grew from below 1000 to above 5000 during these five years, and it peaked in March 2000. Soon after, a wave of panic selling started and a majority of dotcom businesses lost all of their market capitalization – and all of their value.

This example illustrates how it is possible to make the wrong decision even after considering the aforementioned aspects when choosing what to invest in. One group of investors say there is no single indicator that can guarantee that a company is worth investing in. Another group is forever on the lookout for variables, indicators and ratios, analysing price charts and developing complicated formulas to help them make decisions.

One popular formula is the so-called price per earnings ratio, or P/E ratio. It is calculated by dividing the market value per share by the earnings per share and it shows the investor how many invested dollars are expected to bring one dollar of profit from the company. This ratio is generally considered to be a more accurate indicator of a stock’s potential than the market capitalisation.

There are other indicators that are extremely complicated, with no less than intriguing names such as the “moving average convergence divergence”, or the “Chaikin oscillator”.

The bottom line is that while there are many factors that clearly play a role in the increase and decrease of share prices, and many formulas are available to help one make sound decisions, trading on the stock market is risky for a reason. On the upside, it will probably never be accused of being boring.